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February 01, 2016 at 07:00 PM
Is it time to jump out the window? Bad as it may seem, the stock market’s worst yearly start ever — even compared to dreaded years like 1929, 1987, 2000, and 2008 — needs some perspective.
Even after factoring in the fast and furious losses of early January, the SPDR S&P 500 ETF (SPY) is still up 221% while the Nasdaq Composite ETF (ONEQ) is ahead by 284% and the SPDR Dow Jones Industrial Average ETF (DIA) is up 190% since the March 9, 2009 market bottom. In other words, 2016′s losses are still just a flesh wound.
Nevertheless, it would be completely unreasonable to assume the worst is over for the stock market.
Since the 2008 financial crisis, the total U.S. stock market has delivered consecutive yearly gains, lulling many retail investors (and even some financial advisors) into a false sense of comfort. When stock markets only go up, as they have mostly done over the past seven years, people have a tendency to lose discipline and underestimate risk.
While there are differing philosophies about how to best build a portfolio of ETFs, now more than ever, it’s crucial for advisors to have a disciplined framework. During favorable markets, portfolio flaws are masked by a rising tide; but when market conditions are deteriorating, portfolio flaws are exposed. To that end, I’ve developed what I call an “all season” portfolio strategy that has three key cornerstones. Let’s examine them together.
Core Portfolio
An investor’s core portfolio will always have low cost and broad exposure to the five major asset classes: stocks, bonds, commodities, real estate and cash. Instead of jumping in and out of these various asset classes, the core portfolio maintains constant exposure to each of these areas while conforming the portfolio’s asset allocation to the investor’s goals, age, time horizon and risk comfort level.
With the exception of cash, there are plenty of solid core ETF choices that provide broad diversification to each of these key areas. For example, the Vanguard Total World Stock ETF (VT) is a great example of a fund that offers core exposure to the global equity marketplace in just one trade. VT covers 98% of the world’s investable market cap and does it for just 0.17%.
Because people’s core portfolio is essentially the foundation of their entire portfolio, it should never represent less than 51% of their total investable assets. Like a well-built home, the foundation can never be smaller than the structure’s subsequent floors and if it is, the building is at risk of tipping over.
Non-Core Portfolio
In contrast to the core portfolio, the hallmark of an investor’s non-core portfolio is that it has the freedom to invest in non-core assets like individual stocks and commodities, leveraged funds/ETFs, currencies, art and other collectibles, actively managed funds, hedge funds, private equity and venture capital.
Key characteristics of a non-core portfolio is that it is generally more concentrated, more volatile, more active, more expensive and higher risk.
“Tactical” would be a fitting one-word adjective to describe a non-core portfolio. If the stock market is sinking, for instance, the non-core portfolio can own a leveraged short ETF like the Direxion Daily Small Cap Bear 3x Shares (TZA). TZA is designed to increase in value when small cap stocks fall.
Unfortunately, many investors have erringly built the foundation of their investment portfolio with non-core building blocks. As a result, the risk characer of their portfolio ends up being incompatible with their true risk tolerance. And during unfavorble markets or other unforseen events, these incompatiblities can severly impair a person’s net worth and long-term investment plan.
